Understanding Security Tokens
An asset is any resource (tangible or intangible) that can be owned or controlled to produce positive economic value.
Broadly there are four major asset class types: stocks, bonds, commodities and real estate. In 2017, global stock market capitalization is equal to ~$73 trillion dollars. Outstanding global bond market is estimated to be around $127 trillion dollars. Commodity market for gold itself is ~$8 trillion dollars whereas global real estate is estimated to be ~$217 trillion dollars.
Are security tokens or crypto currencies a new asset class?
After Bitcoin emerged as the first successful implementation of blockchain, many others like Ethereum, Monero etc. followed with their own use cases. Financial market regulators were initially sceptical about decentralized control and the rising capitalization of such projects but now they are actively considering to draft regulations and policies for such public blockchain projects keeping the core features of blockchain intact. However, most of the regulatory bodies are taking a cautionary approach. Many startups raised their funding through an ICO (Initial Coin Offering) which were not looked favourably by many market participants and regulatory bodies. In USA, a Securities Exchange Commission (SEC) official had said that Bitcoin and Ethereum cannot be bracketed as ‘Securities’.
But whether public blockchains are regulated or not, what is important is whether the existing asset classification is suitable for public blockchains. According to ‘Howey Test’ a security can be explained as ‘when a person invests her money in any asset and without any additional efforts/involvement from her side makes a monetary return due to the efforts of the promoter/third party operator of the asset, then the person’s investment can be called as a ‘Securities’. Keeping this in mind, even in Bitcoin or Ethereum, a person invests only capital and is not involved or putting in effort to run the blockchains network and thus such investments should come under the definition of a ‘Securities’. As we speak, SEC is working and deliberating whether to classify cryptocurrencies or security tokens under existing asset class or to label it as a new asset class.
What do you mean by Tokenisation?
Simply put it means rights/ ownership of any asset in the form of digital data.
For example, a home owner has certain documents to justify the ownership of his/her home. These documents can be — property ownership papers, property-will, property tax paper etc. In tokenization, these documents are converted in the form of digital data on top of a verified blockchain network.
What are the benefits of Tokenization?
Trustless Ownership — Security token owners will no longer need to trust third-party intermediaries (banks/custodians) to hold custody of their assets. A retail investor will have an option to hold the assets either in her/his own personal wallet or opt for the option of custody. The investor’s digital identity will be linked to his/her personal wallet; thus one can buy or sell security tokens on peer to peer basis between eligible wallet addresses on any blockchain exchange platform.
Cost Effective — Tokenization of existing assets class — stocks, bonds, commodities, real estate etc. will significantly reduce the overall cost for investors. Let’s assume an investor wants to buy shares in a company which has tokenised its equity shares. This investor can directly register on a leading equity custodial decentralized application (Dapp) running on top of any major blockchain say Ethereum. The whole operation of buying/selling/holding of the equity can be performed on a ‘smart contract’ thus eliminating any administrative costs and intermediaries.
Fast — Existing platforms for buying/selling securities can take hours/days to deliver the security (even if it is dematerialised form) and close the transaction. With the integration of multiple Dapps (equity custodial service, personal wallet), funds and underlying securities through tokens can be transferred within minutes. Any investor can sell his/her security tokens from custodial Dapp and transfer the funds in one’s personal wallet within minutes.
Global Accessibility — Similar to cryptocurrencies which are traded 24/7, tokenised assets can be traded globally at all times. Regulation of all tokens will follow a well-crafted standard global framework and each country will adopt the standard framework with certain changes based on the country’s security policies. Thereafter, any company’s equity or any country’s government bond will be broadly accessible globally, not limited to a particular country’s jurisdiction.
Fractional Ownership- With the help of blockchain, fractional ownership of assets can become a reality. A retail investor can invest in Amazon by buying a securitised token which has Amazon equity shares as the underlying. Since tokens can be of any numerical value, the underlying shares can be less than 1 equity share as well thereby enabling smaller retail investors to own fractional assets or equity shares in this case. Fractional ownership provides large access, participation and liquidity to high value assets like real estate.
Regulatory Compliance — Depending upon the jurisdiction, mostly ‘accredited’ investors will be able to invest in security tokens on Dapps, which will be fully regulatory compliant. Regulatory compliance will result in massive investments and participation from both retail and institutional investors. With the help of smart contracts, tokens can be issued and managed transparently on the blockchain which will help the regulators as well.
Popular Security Issuance Platforms
Polymath is a public blockchain based platform that will simplify the creation and use of any securities (Real estate, equities, venture capital fundraising etc.) in form of tokens. Polymath’s blockchain will be fueled by its own tokens (POLY) to power the network. Asset issuers can easily create their own security tokens in form of (ST-20) standard tokens running on top of polymath blockchain. The platform is expected to be fully SEC compliant and will pass through several others regulatory frameworks depending upon the country.
Harbor is also a blockchain protocol running on Ethereum blockchain. It aims to make security asset tokens tradable on any exchange platforms. It provides a common platform for traditional assets such as real estate, equity, investment funds, fine art etc. as well as for crypto-securities running on public blockchains. One of the assets it is currently focusing on is real estate. Currently REITs have several restrictions such as the limitation on ownership as per citizenship, minimum capital requirement, minimum holding period etc. Harbor is addressing these problems with its protocol.
Existing Tokenized Securities
Blockchain Capital — It is the first platform to introduce a public offering for securities tokens. It issued BCAP ICO (Initial Coin Offering) tokens on Ethereum blockchain, the offering was limited to 99 accredited US-based investors. Thereafter Blockchain capital has invested in many blockchain companies such as leading exchanges — Coinbase, Abra, Kraken etc. Infrastructure-based companies as Block.one-parent company of EOS protocol and leading blockchain projects — Civic, Kin etc.
Science Blockchain — One of the leading platforms which raised funds in form of its own security tokens (SCI) and further invested in multiple spaces — blockchain, e-commerce, media, gaming etc.
One of the key challenges to tokenize real-world assets is to ensure the digital asset stays linked to the underlying real-world asset. Pricing of the tokens should reflect the demand supply situation of the real-world physical asset. If security tokens become more volatile or speculative than the underlying assets, investors will lose trust on tokens.
Security tokens will currently fall under existing regulatory rules till new rules are drafted and a standard framework is accepted globally. Existing regulations are made for traditional assets and may not be best suited for digital asset management. Thus integrating traditional securities in form of digital tokens will need larger participation/views from various stakeholders to draft suitable new regulations.
Digital security exchanges will be one of the most important catalysts for the emergence of security tokens. Fractionalization of securities will provide trillions of dollar in liquidity. Centralized digital blockchain enabled security exchanges providing robust custody solutions might attract institutional investors whereas decentralized security exchanges will be widely used by retail investors due to its open, transparent, low cost, borderless nature.
Eventually, traditional securities will be replaced by security tokens. Traditional securities like equity carry additional rights like voting, dividends, buy-back rights etc. Provision of these rights in the tokens will make it easier for investors as well as issuers. Almost every company will have tradable equity tokens. Similarly, every commodity and real estate property will be tokenized. It will be common for Governments, institutions, entrepreneurs & customers to own tiny stakes in businesses, commodities and properties all around the world. It is not far-fetch to think of assets like fine arts, vintage collectables to be tokenized.
In my next blog, we will cover how payment blockchain protocols will disrupt traditional finance businesses.
(This blog series is co-written with inputs from Mr. Kunal Shivalkar, a JBIMS almunus who is a Blockchain enthusiast residing in Hyderabad. You can reach out to him on firstname.lastname@example.org)